The United Kingdom posted the biggest July government surplus in 18 years, according to figures published by the Office for National Statistics. Given the withdrawal of tax incentives for buy-to-let investors and significant income taxes, it is no wonder that the government’s coffers are in better shape. Yet, don’t bet on any significant tax breaks in light of the Brexit uncertainties, an unfunded commitment to spend billions on the NHS and a very high level of debt-to-GDP ratio.
In this day of an age, what is the best move to improve your tax bill? Two words: pension contributions.
Tax relief on contributions.
What is a pension? It is essentially a tax-free saving account for retirement.
Pension contributions are one of the only effective means left in the UK to reduce your tax bill. The Government has a policy goal that incentivizes people to save money for their future retirement. Unlike other countries, a pensioner cannot live off state pension in the UK. The basic State Pension currently stands at £125.95 per week. Good luck living off that amount in London.
Therefore, it is important to save money to supplement the basic State Pension with additional income for when you retire. For each pound saved in your “pension pot,” the Government will give you a tax break. Since 2014, you can start withdrawing funds from your pension pot at age 55.
The basics: tax relief on pension contributions
If you are under 75, tax relief is granted on pension contributions, subject to a £40,000 annual allowance.
If you contribute money into your pension pot yourself, or if it is taken by the employer through your salary (i.e. salary sacrifice), you automatically get a 20% top-up from the Government. Note that this is not the Government giving you back 20% of the amount contributed via a transfer to your bank account. Instead, the Government will add an additional deposit worth 20% into your pension pot.
If you are a higher rate taxpayer (i.e. marginal income tax rate at 40%) or an additional rate taxpayer (marginal income tax rate at 45%), you can claim respectively claim an extra 20% and 25% tax relief. If you contribute through your employer’s scheme (i.e. through “salary sacrifice”), you may not have to reclaim this additional tax relief if your employer ends up deducting fess taxes from your salary. If your employer does not reclaim the tax relief on your behalf, then you have to make the claim yourself to HMRC by completing a self-assessment tax return.
There are therefore two ways to contribute to your pension pot: through your employer’s salary sacrifice scheme (if your employer operates such a scheme) or by simply transferring the funds to your pension provider. As a rule of thumb, it is better to use your employer’s salary sacrifice scheme if available for two reasons.
First, your employer deducts your contributions from your gross pay, before deducting taxes. In other words, your employer puts the cash straight in your pension pot from your gross pay so your contribution is never taxed in the first place. There is no need to claim when completing your self-assessment and then wait for HMRC to reimburse you the difference. This is called a net pay arrangement.
Second, as your pension contribution is deducted from your gross salary, you also avoid the full paying national insurance contribution and taxes on your pension contribution. As a basic-rate taxpayer, you avoid 12% of National Insurance contributions on the amount contributed to your pension pot. As a higher rate and additional rate taxpayer, you don’t have to pay the 2% rate. As a reminder, all taxpayers pay 12% of their earnings above £162 a week and up to £892 a week. For earnings over £892 a week, the rate drops to 2%.
On the contrary, if you wire the funds yourself, you will have paid national insurance contributions and income taxes on that amount. You will have to reclaim the income tax relief when completing your self-assessment form, which takes longer. As the tax relief is only available for income tax, you will not be able to reclaim the national insurance contributions.
Below is a brief summary to illustrate the income tax boost:
As you see, higher rate and additional rate taxpayers will effectively disburse less money but will end up with the same amount of contribution as a basic rate taxpayer due to the higher tax relief that they get. For years, pension contributions have been the most tax efficient way to stash cash for high earners. New rules introduced in the past few years have significantly reduced the tax relief available to high earners.
Limits on how much you can contribute
There are limits on how much you can contribute so that people cannot take advantage of the tax relief forever.
Limit on Earnings: tax relief on pension contributions is only available up to your annual earnings. Therefore, if you earn £30,000 a year and want to contribute a lump sum of £40,000, you can only get tax relief up to £30,000.
Tapered allowance (high earners only): you can only contribute up to your allowance, which is made of £40,000 (base allowance) plus any unused allowance from the previous three tax years. Since April 2016, any high earner making more than an adjusted income of more than £150,000 will be subject to the tapered annual allowance. The more you make, the more your allowance is reduced, which means that a lower amount of pension contributions is eligible to tax relief. Once your adjusted income is £210,000 or more, your annual allowance is reduced to £10,000. Presumably, the assumption is that high earners can use supplement their savings through other instruments such as ISA accounts or other investments. Those who make less than £110,000 are not affected by this change.
Lifetime limit (mostly relevant to high earners): In the 2018/2019 tax year, the lifetime limit is £1,030,000. If your pension pot is above the £1,030,000 threshold, you will not get tax relief on additional contributions.
How to optimize your pension contributions
Employer’s pension
If you are employed, your employer may top up your pension contribution. For instance, my partner’s employer has the following bands:
| Employee’s contribution | Employer’s contribution |
| 1% | 2% |
| 2% | 4% |
| 3% | 6% |
As you can see, her employer doubles the employee’s contribution up to 3%. Subject to the above-mentioned caps, this is essentially free money (or a pay rise). 2% of your salary is unlikely to make a big difference in your day to day lifestyle. However, an additional 3% a year from your employer will make a significant difference over the years thanks to compounding interests. Therefore, you should absolutely max out your pension contribution. If your employer matches your contributions, make sure you contribute as much as possible.
My former employer offered a generous 5% contribution but did not top up. Whether I contributed 1% or 10% of my salary did not make a difference.
Contributing to your pension or paying off debt?
The more you contribute to your pension, and the sooner you start, the better your retirement income will be because your pension pot will have had more time to grow. The benefits stemming from the tax relief and compounding of interest will help you in increasing your pension pot.
Contributing to your pension is still a sacrifice of short-term cash for the promise of a larger amount in the future that will serve you in retirement. Is it still worth contributing to your pension if you have outstanding debt? As a rule of thumb, I would advise repaying the debt first, especially if we are talking about credit card debt or student loans. For a mortgage, the reasoning is a bit different: as you will probably take over 15 years to repay that mortgage, you should not postpone contributing to your pension for such a long amount of time. It is better to repay your mortgage and contribute small amounts to your pension pot, rather than repaying your mortgage in a hurry but with no retirement pot in sight. Obviously, don’t borrow to increase your pension contributions as this will prove unsustainable very quickly.
Watch out for those management fees
Pay off your debt and then contribute to your pension pot as much and as soon as possible. One additional area that tends to be neglected is the fees charged by the pension provider. There are many pension providers (Scottish Widows and Aegon are amongst the most common ones (note, I refer to those providers because I have or held an account with them but I don’t get paid to mention them)). In truth, I tend to think that all providers offer similar funds and strategies. What differentiates them is the amount charged in management fees. A management fee of 0.50% will end up costing you thousands of pounds more than a fee at 0.25%. It is not just because you are paying a higher fee. You are also missing out additional interest and capital appreciation that would have had a compounding effect, and therefore made you even more money.
Are there alternatives to the pension pot?
The sad reality is that even if you reach the £1,030,000 threshold, this might not be sufficient to sustain your lifestyle in retirement. You, therefore, need to create additional saving pots: the Lifetime ISA is one possible option but it remains to be seen for how long it will remain available. There are few providers of LISA and I would not be surprised if the Government decided to scrap the scheme at some point. A standard cash ISA is better than nothing although the saving rates won’t get you very far. You may be better with a stock and share ISA, but only if you are still far away from retirement.
If you are not contributing to a pension, you are essentially forfeiting your future. You will have no choice but to work forever. Even if you are lucky to have a good health, potential employers may be unwilling to hire due to your age. It is therefore important that you remain on top of this topic. We will regularly update and add to this post when significant developments are rolled out by the Exchequer and HMRC. Make sure you understand this cheat sheet and check regularly for updates.
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